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The Truth about Low Volume ETFs - Investment Ideas

Although ETFs have begun to surge in popularity over the past
few years, there are still a few misconceptions about how the
products work. While mistakes are often made when it comes to how
to utilize leveraged and inverse funds or commodity and volatility
products in a portfolio, another key aspect of ETF investing
afflicts nearly all investors no matter the product type;
volume.

Volume, or the number of shares trading in a particular period,
is regarded by many as the basis for liquidity in the stock world.
The more shares that trade in a particular security, the easier it
will be to move in and out of it, keeping bid ask spreads tight for
popular stocks (see the
Three Biggest Mistakes of ETF Investing
).

When investors apply this logic to ETFs, the resulting thinking
is that high volume funds are extremely liquid while low volume
ones, much like thinly traded stocks, should be avoided by most.
After all, it is only natural to assume that ETFs are like stocks
in this regard as both are exchange-traded and many ETFs are just
baskets of stocks anyway.

However, this isn't always true as, unlike a regular stock, an
ETF doesn't rely on its actual volume to generate liquidity.
Instead, an
ETF's volume is dependent on its underlying holdings for its
actual liquidity
.

Say What?

The above statement is true because of how ETFs are structured
and how new shares are created in a fund. Basically, what is called
an Authorized Participant (AP) can step in and buy up securities in
order to create a new basket of ETF shares, or trade in ETF shares
for underlying securities as need be.

Due to this feature, ETFs often trade quite close to their net
asset value (NAV), since when prices deviate too far-either high or
low-the Authorized Participant can step in to balance the process
out. Thus, when ETF prices are too high compared to the NAV, the AP
creates more ETF baskets while when the ETF prices are below the
NAV, the shares are traded in by the AP for the underlying
securities.

The AP profits from the spread differential in this
arbitrage-like move, which also helps to keep ETF prices in line
with their NAV so that everyone wins in this creation and
redemption process (read
ETFs vs. Mutual Funds
).

Why is this important?

This is key because many investors in ETFs were stock buyers
first who are now beginning to see the promise of using
exchange-traded funds in their portfolios. Due to being conditioned
to apply stock logic to ETFs, many may be unfamiliar with the
creation and redemption process and assume that if a low volume ETF
isn't trading frequently that it will be unable to be bought and
sold regularly and easily throughout the day.

In other words, while stock volume is limited to the float of
the particular security, ETF volume is limited to the float of all
its underlying securities and the ability of an AP to buy or sell
them on an open market. Basically, if an ETF invests in liquid
securities, it will generally be easy to trade, regardless of the
current volume levels you are seeing.

Take for example the
WisdomTree LargeCap Value Fund (
EZY
)
, a product that has just $30 million in AUM and volume of just
3,000 shares a day. While at first glance investors might
automatically avoid the product, a closer look at the holdings
reveals a different story (read
Try Value Investing with These Large Cap ETFs
).

The ETF's top holdings consist of some of the most liquid and
widely held stocks in the U.S., including
ExxonMobil (
XOM
)
,
Apple (
AAPL
)
, and
Chevron (
CVX
)
. All of these stocks trade at least six million shares a day, how
difficult could it be to a build a basket with stocks like
those?

Caveat to Low Volume ETFs

With that being said, investors should note that low volume ETFs
still face some issues that their high volume counterparts do not,
namely in the form of bid ask spreads. Low volume funds generally
have a wider bid ask spread, a factor that can add to total costs
when compared to their more liquid peers.

This also means that limit orders will definitely be necessary
for low volume ETFs as well. Since the bid and the ask spread is
much wider in these funds, one must set a tight asking price in
order to get into a particular security at a good price (read
Two ETFs for the Muddle Through Economy
).

Furthermore, not all market segments are created equal and some
will necessarily be more liquid than others. For example, those
following large cap U.S. stocks are likely to have an easy time
with the creation and redemption process, while those that target
niche small cap U.S. stocks may find it a tad more difficult.

The same can be said for (especially) bond products and
international markets as well. While these securities are
relatively effortless to get your hands on if you are an AP, it is
undoubtedly easier for
EWC
to build a basket of Canadian stocks than it is for
IDXJ
to find and easily trade in small cap Indonesian securities.

Still, no matter the volumes of these aforementioned funds,
similar products tracking like indexes will probably face
comparable issues when it comes to creating and redeeming baskets
of the underlying ETF.

For example, both the
iShares MSCI Russia Capped Index Fund (
ERUS
)
and the
SPDR S&P Russia ETF (
RBL
)
follow large cap Russian stocks. However, RBL has a volume that is
roughly one-tenth of ERUS, and AUM that is a fraction of its more
popular counterpart (read
Seven Biggest International Equity ETFs
).

Yet, when one looks at the holdings, the funds are strikingly
similar as all of the top three holdings are identical,
representing close to 50% of assets for both ERUS and RBL. So
although ERUS has a (slightly) tighter bid ask spread and more
volume, it is unlikely to be that much more liquid as it is
targeting-more or less-- the same securities for its ETF baskets as
its more thinly traded counterpart.

So, the moral of the story is that low volume ETFs shouldn't be
automatically dismissed from the get-go. While investors will often
have to pay a few basis points more thanks to the bid ask spread,
the product will still be easily tradable so long as its underlying
securities are sufficiently liquid.

As a result, the next time you see an interesting low volume
ETF, take a closer look at its holdings and current spread instead
of immediately crossing it off of your list. The ETF may not be as
off-limits and as impossible to trade into as you may have
initially thought before you understood the truth about the low
volume ETF world.

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